Business Valuation in the Context of Fraud or Misrepresentation
Since the global financial crisis, disputes arising from major corporate M&A transactions appear to be on the rise. This is particularly true in Asia, where investors are in an unfamiliar environment and negotiating with local businesses that have yet to reach maturity. When post-acquisition disputes do erupt, they frequently refer to allegations of misrepresentation or fraud, with the concerned parties engaging in litigation or arbitration to resolve their disputes. In such cases, questions can arise as to the true value of the acquired business. Yet valuing businesses in such circumstances brings a unique set of challenges, as Managing Director Mustafa Hadi discusses.
“HP Alleges Fraud In Autonomy Deal; Takes $8.8B Charge” proclaimed a newspaper headline in November 2012.1 A similar news story referring to the acquisition of a company in Asia by Caterpillar Inc. a year later read: “Cat Scammed: How A U.S. Company Blew Half A Billion Dollars In China.”2 In the post-financial crisis world, disputes arising from large corporate M&A deals appear to be on the rise. Such disputes are particularly common in Asia, where foreign investors acquiring local companies operate in an unfamiliar business environment, and where standards of corporate governance and regulatory scrutiny are often not as mature as in more developed markets.
International arbitration is increasingly the dispute resolution mechanism of choice for cross-border investors. As cross border investment continues to flow into (and increasingly out of) Asia (see Figure 1), it is likely that some cross-border acquisitions will result in disputes, and that many of these disputes will be resolved through arbitration. Post-acquisition disputes, which often relate to allegations of misrepresentation or fraud by the vendor, can require various, interrelated, questions of value to be addressed. Questions such as, ‘What is the true market value of the company acquired?’ or ‘What would the acquirer have paid had it been aware of the true financial performance of the target company?’ are commonly raised in the dispute resolution process. This article considers the common issues that arise in valuing a business following the discovery of fraud or financial misrepresentation.3 we begin by describing certain relevant principles of business valuation.
The Fundamental Drivers of Business Value
The Fundamental Drivers of Business Value Fundamentally, the value of a business (like any other asset) arises from its ability to confer economic benefits upon its owner. In the case of an operating business (as opposed to an investment holding company) that is a going concern, its value arises principally from the future operating profits it is expected to generate.4 Two other factors are also relevant: (i) the risk, or uncertainty, associated with the expected future profits, and (ii) any non-operating assets owned by the business. Risk is significant because investors are risk-averse (i.e. they will not accept additional risk without being compensated for it in the form of greater returns). All else being equal, a rational investor will place a lower value on an asset that has greater uncertainty concerning its future economic benefits.
Non-operating assets are assets that are not employed in generating the operating profits of the core business, such as investments in surplus real estate or financial assets. Non-operating assets can include cash, where it is surplus to the operating requirements of the business — a well-known example of this being that of Apple Inc., which amassed a cash surplus approaching US$100 billion prior to initiating a distribution to its shareholders in 2012. Such assets represent a source of value additional to the operating business, since they can be disposed of or put to other uses without the operating business being affected. Similarly, if a business does not possess all of the assets required to continue its operations (for example, if it has a deficit of working capital) this will also impact business value. This is because additional investment will be required to continue operations.